Cerner: What seems to be a massive case of "Growth-itis."
For many years, investors have looked to invest in the healthcare IT space. What could possibly be a better investment than to invest in a technology that promises to improve the efficiency of super-expensive healthcare systems in this country and around the world? What could possibly be a better investment than something that would lead to better patient outcomes, enhance healthcare privacy and provide for the more efficient operation of healthcare facilities? Something serious has happened on the way to the cash register. Yes, there is a certain level of maturity and saturation in core electronic health record technology (EHR). But there are plenty of greenfield opportunities, and even in the so-called saturated areas, there are many pockets of potential customers who use a minimal amount of obsolescent technology. And most EHR technology is old now, and much of it needs replacement for functional reasons.
Cerner (NASDAQ:CERN) has been the leader amongst publicly traded medical IT firms for some years now. Once upon a time, it was considered to be a hyper-growth company and garnered high valuations. Lately, growth has stagnated significantly and the company has exhibited many signs of middle-age stress. Why is that?
Part of the article will attempt to understand the factors that have inhibited growth at Cerner and have made it hard to rely on company guidance as a completely accurate forecasting tool. Needless to say, the article will also encapsulate the results of both the company's fiscal Q3 that ended 9/30 and its current guidance. The news part is lots easier to do than the part about why it is having growth and forecasting problems. It would be easier to attempt to write intelligently if management acknowledged problems. That is not the case - at least thus far - and hence, lots of what I have to write is more speculative than grounded on solid, observable facts.
But the fact is that three of the three largest companies in the healthcare IT space have had operating problems this year and have seen significant share price compression. The trends of Epic, one of the other major companies in the competitive landscape, are not known as it is private. Some of Cerner's growth issues are almost certainly related to the teething problems it is having with the merger with Siemens (OTCPK:SIEGY) and the issues with users migrating from Sorian Clinical. While most of those users will wind up choosing another Cerner solution, the process of migration has been slow and fraught to a greater or lesser degree. Sorian is considered antiquated and non-competitive, but the acquisition was more about acquiring customers than technology, according to most observers.
Cerner shares are down 21% YTD, and those results are actually better than those of its principal publicly traded competitors, athena (NASDAQ:ATHN), whose shares are down by 41% so far this year, and Allscripts (NASDAQ:MDRX), whose shares are off by one-third so far in 2016. Cerner shares hit an all-time high of $75 in April 2015 and are down more than one-third from that point. The company has been able to grow a bit - just not fast enough and not consistent with the guidance provided by management. Shares have now been caught up in the tech stock contraction and have lost another 6% of their value just since the end of November. When sentiment turns, valuation logic goes with it and oversold indicators mean very little.
On the face of things, it appears that healthcare IT is sick, or at least not in the state that might be reasonably expected, and that might be a function of Obamacare costs crowding out other potential investments or some other factor. Jonathan Bush of athena is always worth a quote on the subject. There is no consensus view that the CAGR in the EHR space has compressed. It would not be surprising that in the wake of a very volatile outlook for the state of government healthcare programs and reimbursement policies buyers were not trying, where they could, to delay decisions. It is the prudent thing to do.
Cerner is no longer a particularly expensive investment - or that would be the case if it gets back on track and achieves the preliminary guidance it has given for 2017. At the current share price, it has a market cap of $15.9 billion. Its current net cash balance is about $265 million, which results in an enterprise value of about $15.65 billion. With sales projected to be $5.3 billion next year, the EV/S has shrunk to 2.95X. Not perhaps a deep value name, but cheap enough if the company can just achieve its guidance and return to double-digit growth.
It is funny, perhaps, or perhaps just a function of the world in which we live. But Cerner, at the current valuation, is far less well regarded by analysts on First Call then it was when it was much more highly valued. At the moment, it has 16 buys and strong buys, 8 holds and the equivalent of a sell from Bank of America. And yet, the average price target is $61, the equivalent of 26% share price appreciation - the low price target is $50. It is interesting to have a sell recommendation on a company whose shares are less than one's price target, but such are the vagaries of professional analysis in the second decade of this century.
The short interest is not insubstantial and has continued to grow. As of the last reporting period, the short position was 18.6 million shares, up 2 million shares in a month and now at 6%-plus of the float. That is a significant level for a company trading at its 52-week low.
My own record with the shares has been less than exemplary. I initially wrote on the name in February, when the shares were at $51 in the wake of a weak quarter that ended 2015. The shares did quite well subsequently, and I was clever enough to press my bets in August, when the shares were $66, although with some measure of caution. Hardly the best call I have made this year.
At this point, I like the bet that Cerner shares present. Much of the negative sentiment surrounding the name has to do more with optics and communications than some drastic market implosion or loss of competitive position. Business with new names is strong, and the bookings shortfall, while real enough, is not totally a function of the company's ability to close the software business. With the valuation implosion, the shares make lots of sense to me, although I do not currently have a position in the name.
Just the financial facts
Cerner sells both hardware and software, and also is in the midst of transitioning its software sales of a subscription model. For the most part, bookings are the more important metric to consider. In a typical year, almost 80% of the company's reported revenues are converted from the balance sheet, and that has been the case both this year and in times past.
Sales last quarter crept up by 5% and were less than 2% below guidance. Bookings were down 10% from the corresponding period in 2015, when they had grown 44% from the prior year to an all-time record. Again, the growth last year had lots to do with the Siemens acquisition and the contraction this year has more than a bit do with the loss of some Siemens customers deserting its Sorian technology.
Bookings for Cerner have moved an uneven cadence and have averaged below management guidance for the better part of 18 months now. Gross margins moved up by more than 100bps, primarily as a function of the company selling less pass-through hardware and selling more software and services.
The company was able to maintain non-GAAP operating margins at 24%, flat and consistent with guidance. It reported an increase in sales and client service expense of about 19% on a GAAP basis. During the conference call, the CFO said that the noticeable increase which accelerated last quarter was related to higher personal costs for its sales operation. Although there was a decline in software service bookings last quarter, it was significantly offset by increases in subscription and hosted bookings, which mean more over an extended time period. Cerner paid more commissions because it is "selling" a greater quantity of solutions.
The company announced a voluntary separation plan to reduce headcount marginally. It continues to hire on a net basis - this is more in the nature of a cull of the most expensive employees. Cerner is forecasting that non-GAAP margins will rise at some modest rate next year, and it needs to manage costs carefully to ensure that's going to happen. Many other vendors of this size have significantly higher operating margins than 24-25%, although the 25% of the company's business that is more or less a pass-through, i.e., hardware sales, makes comparisons a bit difficult. I think cost management is likely to be a significant management focus in the next few years - there is a trade-off between growth and operating margins that has yet to be optimized by this company.
CFFO declined from the prior year by a modest amount in Q3. CFFO for the year to date has risen by 35%. Of that increase, a significant component was driven by a noticeable reduction in receivable balances due to an improvement in the DSO metric. Capitalized software development costs continued to rise noticeably. The company's reported research and development expense at 12% of revenue significantly understates both the amount and trend of development costs being incurred.
Cerner guided Q4 results to be modestly below the prior consensus. It is expecting 7% year-on-year growth in Q4, which is a factor of lower growth in what the company calls system sales. It forecast EPS below the consensus as well. Perhaps of more importance to this writer, and more importance to results in the long run, is the expectation that bookings will show 11% growth in Q4. If that happens, despite the many and varied miscues during the course of 2016, the company will achieve bookings of $5.5 billion, ahead of its target and $500 million greater than reported revenues.
Forward guidance for 2017 represented a modest guide-down from prior consensus expectations. The expectations that were set during the conference call last month have now become the consensus. The guidance calls for 11% growth in revenues, 13% growth in bookings and a 13% growth in EPS at the mid-point. I think it is reasonable to suggest that if Cerner does achieve the expectations it provided on the Q3 call, the shares will finally show some sustained positive alpha. The question is not what will happen if the company operates to plan, but what are the issues concerning its plan.
Bookings: They come in all shapes and sizes
I don't think dealing with software companies has ever been simple. There have always been aspects of accounting that were arcane and not subject to universal agreement. It is also said that complaining about changes is a sign of old age. I can't deny I am older, but I do think that the complexity of financial reporting in the software business has become far greater than heretofore with the advent of the cloud, subscription bookings and, of course, the ubiquitous stock-based comp. I'm not going to resolve the later - no one can, and readers will consult their own predilections as to how they look at that metric and what it does or does not do to comparative analysis. (As mentioned below, stock-based comp at Cerner is not particularly elevated, and it isn't rising either.) I don't much like it, but in looking at cash flow, it is hard to say that cash flow doesn't include the cash from converting a cash payment into shares. I usually note the metric and its trend and pass on to other topics.
Cerner does have different classes of bookings. There are bookings of hardware and software, long term and short term. There are metrics that involve the translation of converting bookings to revenues. There are managed services bookings, and there are bookings of new name accounts.
Last quarter saw a more normal mix of longer-term bookings at 34%. I think it becomes more than a bit tendentious for investors to compare long-term and short-term bookings. I recently wrote about Workday (NYSE:WDAY) and how the tendency for users to migrate to shorter-term bookings has led to a major change in the company's bookings forecast and a huge share price debacle the other day. Some of that same phenomenon is at work here, although not from the same causes or with the same cadence. But I think in characterizing the bookings miss last quarter, it is fair to say that it was a bit less dire than met the eye.
Looked at a bit more carefully than just the headlines, while Cerner is not having a stellar year, its bookings miss is centering on sales of hardware, which is a low-margin, pass-through business. It has been the fact that the bookings mix has centered in the hardware line that has allowed Cerner to achieve its EPS guidance So, despite the booking misses in the past quarter, the EPS guidance remains intact for this year, and overall, the company has seen increasing backlog. Since 80% of revenue comes from the backlog, at least on a headline revenue basis, it is important for backlog grow.
I'm not going to attempt to move through all of the product areas that this company offers. The fact is that it has one of the more complete set of solutions of any of the companies in the medical IT field - it is said to have the largest market share. There are companies who specialize in cranking out research reports on the medical IT area - all I can do is synthesize what they have to say on the subject. It's difficult for anyone to have a precise view on the competitive positioning of all of the competitors in all of the different areas that make up medical IT or easier, notes Electronic Health Records (HER). Gartner has listed Cerner as a leader in the MQ for the electronic health record space for many years now, and it still does. The fact is that Gartner list no fewer than three Cerner solutions in its study, two in the visionary quadrant and one as a leader.
One issue faced by Cerner is that the EHR market is not expected to grow particularly rapidly. The CAGR projected by most studies is a bit over 5%, so to grow in double digits requires the company to either gain market share or sell in different markets. The latest reports suggest that the company is slightly larger than its chief rival, McKesson (NYSE:MCK), in the space, partially due to its acquisition of the HER operations of Siemens in 2015. At the moment, the survey says that there are no fewer than 1,100 competitors in the healthcare IT space - an unsustainable amount of choice that will almost certainly diminish over time due to mergers & acquisitions. And it is really difficult to discern major functional differences between the offerings. Some offerings are focused on physicians, others on different sizes of hospitals - but there is nothing outstanding, one way or the other, that distinguishes one vendor from another in terms of the functionality within a specific category.
Growth delayed or growth foregone - are there real answers for that question?
At this point, and given the very uneven performance of this company during the course of the last 18 months or thereabouts, I think that is a reasonable question. See how you feel about this Q&A: "And then, what gives you guys confidence that it's sort of just getting pushed over to a little bit further down the road and not necessarily disappearing? Are they (customers) putting anything into their budgets for next year that gives you that confidence, or any other metrics that we can rely on?" Answer from Cerner President Zane Burke: "... in the new business marketplace I'd say our metrics are at all-time highs. So the activity levels are incredibly good, and in fact, we had a very strong new business quarter overall, So we did very well. We just had anticipated doing slight better." Answer: "So, the budgets are there. The activity is there and we are - we had a high-performance quarter in terms of numbers. We did not meet our expectations in what we anticipated to come through for the quarter. So, and as we look forward, we see our pipeline of activity and those that are in the pipe as very strong. And record levels of activity there." Additional answer from Marc Naughton, CFO: "The process will remain as it's always remained. We will look at the business. We won't make any assumptions that we are going to grow bookings. We will expect booking to be relatively flat, a mix to be relatively similar. And we will then look at our forecast and see how the forecast supports those assumptions. We'll do all the things we do relatively looking at spending and looking at opportunities."
Just to be completely clear, the CFO was talking about the methodology and not the expectation for bookings. The next questioner was pretty frantic on that point - but the forecast I wrote about above is the one that management is using at present. All that the CFO was saying was that they use a zero base of assumptions and then see where the exercise takes them, and that they do not put their thumb on the scale with some pre-ordained assumption for growth.
And thus we find that the analyst consensus forecast for revenues is now a bit below the company guidance, and that the analyst consensus for EPS is slightly below the mid-point of the guidance range. Analysts have dropped their estimates about 4% in terms of EPS in the last 90 days, which is a healthy process in terms of setting up for potential beats.
OK, we heard the management answer - stick your neck out.
Management's answer quoted above is about what most readers who have looked at misses hundreds of times in their investing career might anticipate: timing. A few slipped deals at the end of the quarter have gotten blamed for misses as many times as I have enjoyed hot dinners. And I'm not known for pushing away from the table. I do think there is a timing issue in terms of the company closing large EHR replacement deals that has most to do with the changing political environment. And I further think the experience with Sorian has neither been seamless nor quite what management anticipated.
Do I think the company will achieve its target for double-digit growth in bookings and revenues in 2017? Yes, I do. I think there are good reasons to believe Cerner will achieve its revised guidance for both the current quarter and for 2017. I like the success the company has had with its new business component. It suggests to me that its competitive position is healthy and that demand for EHR technology isn't contracting.
And in the "better late than never" category, I think the opportunity the company has and is apparently starting to realize with its CernerWorks hosting platform is probably under-recognized by many. In addition, a new government law called MACRA (Medicare Access and Chip Reauthorization Act) and the MIPS (Merit-based Incentive Payment System) are both likely to be demand drivers in Cerner's space next year. These kinds of new government regulations have often had an outsized effect on the buying decisions of users, who must comply with another round of regulations if they wish to get reimbursed.
In addition, it seems likely that the incoming administration is going to focus on making the VA more responsive to users of its health services. As some readers know, Cerner won a big supply contract at the DoD last year, and it is possible that the implementation will be accelerated and the scope will be broadened by the new administration in its effort to improve the quality of healthcare for veterans.
Obviously, 2017 will see significantly easier comparisons than has been the case in the year just ended. And presumably, management will tend to behave in a slightly chastened fashion in providing bookings targets going forward and the target set for 2017 is biased on the low side.
I think the valuation of Cerner can best be characterized as growth at a reasonable price (GARP). It is not deep value, but shares no longer represent expectations of scorching growth either. As mentioned earlier, Cerner's EV/S based on the current guidance is a bit less than 3X. Its P/E, again based on the current earnings consensus, is a bit over 18X, putting the company solidly in GARP territory. While cash flow this year has increased substantially, some of the increase has been the result of unsustainable factors, such as a material decrease in receivables and a material increase in capitalized software. Those factors are simply not going to produce positive trends for any extended period. During the call, management addressed its need for gross research and development spend of $700 million annually. Since it will report GAAP research and development spend of less than $500 million this year, it might suggest that the benefit from capitalizing software is reaching a peak. Management suggested that this trend would be accounted for in 2017.
Overall, free cash flow is trending toward a level of between $325 and $350 million. That includes a significant spend for the company's new headquarters campus. Next year, CFFO will probably grow at moderate levels based on all of the factors I have tried to mention. CapEx is forecast to decline. That suggests free cash flow in the range of $475-525 million. At the mid-point, that produces a free cash flow yield of a bit over 3%. Not fantastic, but certainly decent compared to alternatives.
The company's use of stock-based comp has been quite small and is not increasing significantly. Stock-based comp is about 7% of non-GAAP earnings, although it is a greater proportion of free cash flow.
At this point in its history, I think Cerner has become an acquisition target. Its size and valuation are such as to be attractive to companies such as IBM Corp. (NYSE:IBM) that want to bulk up in the healthcare IT space. There would not appear to be any current merger premium baked into the valuation of Cerner shares.
And speaking of alternatives, Allscripts, which is forecast by the consensus to grow at the same rate as Cerner, down sharply from earlier periods, has a P/E of 15.6X and an EV/S of about 1.5X. Those valuations suggest that Allscripts may be interesting as an investment as well. Its shares have an even lower analyst recommendation than do the shares of Cerner. athena is clearly in share price purgatory, and that is hardly surprising for what used to be a highly valued name. It's still forecast to grow around 17-18%, but has a P/E of almost 50X. The EV/S is about 3.6X, but the company has a very modest level of free cash flow.
As these things go, Cerner would appear to be the safe, conservative choice. I think CERN shares can produce significant positive alpha going forward.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.